A decade ago the Chinese directors Zhang Yimou and Chen Kaige were the kings of the arthouse world. Their films, including Raise the Red Lantern and Farewell My Concubine, reaped respectable box-office, critical praise, and an astonishing haul of awards at major festivals: six prizes at Cannes, five Oscar nominations, Baftas, awards at Venice and Berlin.

Fast-forward to the present day and awards ceremonies are dominated by Iranian directors. Zhang's last two releases, Not One Less and The Road Home, were well received and won awards, but the public has almost ignored them. His next release, Happy Times, due in September, seems set to suffer a similar fate. Chen has fared even worse after an ill-advised switch to English-language film-making that resulted in the critically mauled sex thriller Killing Me Softly. At the same time, films by younger Chinese directors - such as the recent Shower and Beijing Bicycle, and this week's Platform - stand little chance of scaling the heights of Chinese film's golden years.

Outside the People's Republic, Chinese cinema has been doing magnificently. Beyond the flow of Hong Kong talent and techniques to Hollywood, the arthouse directors of Taiwan and Hong Kong, such as Edward Yang and Wong Kar-wai, are enjoying considerable success. And then there was the world-beating phenomenon of Crouching Tiger, Hidden Dragon. So why has mainland Chinese cinema faded into insignificance?

Part of the answer lies in the question of what made Chinese cinema so great in the first place. When Zhang and Chen came on to the scene, China was still effectively a closed country, its film-makers forced to operate under restrictive conditions in state-run studios. Zhang, Chen and other members of the so-called Fifth Generation were students of the Beijing Film Academy. During the cultural revolution Chen had had to denounce his own father, while Zhang had been ostracised for his father's counterrevolutionary activity and made to work in factories for 10 years before being allowed into film school.

By the time they graduated, Chen and Zhang had developed a healthy contempt for their country that they were unable to express directly. Starting with 1984's Yellow Earth (directed by Chen and filmed by Zhang), the Fifth Generation produced a run of sumptuous films - many starring Zhang's then partner, Gong Li - that combined technical excellence, high drama, social history and veiled political rage.

Festival juries tend to love this kind of thing, especially when it comes out of a politically repressive and relatively unvisited part of the world. Zhang and Chen's films were almost all banned in China, made with foreign assistance and shown at festivals without the approval of the Chinese authorities. The awards stacked up; so did the foreign financing and the international distribution deals. Everybody was happy. It couldn't last.

Flush with cash and kudos, Chen upped the stakes with 1999's The Emperor and the Assassin, a historical drama starring Gong Li and several thousand sword-waving extras. At the time it was the most expensive Chinese movie ever made, but it recouped only a small fraction of its costs. Meanwhile, the Chinese authorities' patience with Zhang ran out. After he screened his film To Live at Cannes without their permission in 1994, he was banned from receiving foreign assistance for five years.

By the time Zhang returned, the arthouse baton had moved west. International audiences were now getting worthier, riskier and more exotic cinema from modest Iranian directors such as Abbas Kiarostami and Mohsen Makhmalbaf. Zhang's comeback film, Not One Less, appeared to acknowledge this. It featured struggling children in poor rural settings: it was Kiarostami in China.

While the Fifth Generation was going global, a Sixth Generation was waiting in the wings. Also graduates of the Beijing Film Academy, these film-makers rebelled as much against the glossy historicism of their predecessors as against the Chinese authorities. What the cultural revolution was to the Fifth Generation, the 1989 shootings in Tiananmen Square were to the Sixth. Their films were usually made illegally, cheaply and angrily, combining punk spirit with Italian neo-realism. They depicted modern Chinese cities as places of poverty, misery and hopelessness.

Zhang Yuan's 1993 underground hit Beijing Bastards, regarded as China's first independent movie, showed Chinese youths having sex, taking drugs and rocking out just like any other disaffected teens. His controversial East Palace West Palace was the first Chinese film to address homosexuality.

Zhang's classmate Wang Xiaoshuai based Beijing Bicycle on De Sica's Bicycle Thieves. His earlier film Frozen followed a Beijing artist who commits suicide; it was filmed under the pseudonym Wu Ming ("no name"). And Jia Zhang Ke, director of Platform, turned in Xiao Wu, a Bressonian portrait of a pickpocket in squalid modern-day Fengyang, made without the authorities' permission.

The Sixth Generation's films also won prizes at the festivals (when they could get them out of China) - but perhaps out of respect for the personal risk involved in making them rather than the experience of watching them. These films' drabness, slowness, emotional detachment and heavy cigarette consumption corresponded to the reality of present-day China, but not necessarily the tastes of international audiences. If the Fifth Generation's films were like a stay in the Beijing Hilton, the Sixth Generation experience was like a night in a backpackers' hostel.

In recent years, however, the Chinese film industry has changed so rapidly as to make the whole "generations" system irrelevant. Since China joined the World Trade Organisation last December, the official studio system has become only one of several options for film-makers. Independent companies are making new types of Chinese films, directed primarily at China's burgeoning domestic youth market and intended to make money rather than win prizes - a difficult prospect in a country where most films are pirated within days of their release. Imar films, set up by a young American producer, Peter Loehr, has paved the way. Imar's prize director, Zhang Yang (another Zhang), has scored two massive domestic hits with his films Spicy Love Soup and Shower, the latter of which also did well internationally. Both are uncontroversial, apolitical urban comedies, made with the full approval of the censors.

At the same time, having absorbed the influence of Chinese cinema so well, Hollywood and international companies are setting up camp in China, particularly the Sony-owned Columbia Tristar. Their projects (which must find Chinese co-producers) range from mid-budget crossover movies such as Sony's Big Shot's Funeral, a Beijing comedy starring Donald Sutherland, to grander period thrillers such as Purple Butterfly (set in 1940s Shanghai and starring Zhang Ziyi - who seems to be the new Gong Li).

But most of these are action epics along the lines of Crouching Tiger, Hidden Dragon. There is The Touch, for example, a calculated blend of Crouching Tiger, Indiana Jones and Cirque du Soleil that is directed by Peter Pau (Crouching Tiger's cinematographer) and stars Michelle Yeoh (Crouching Tiger's heroine). Then there is a Crouching Tiger prequel, produced by Ang Lee and directed by his brother, Lee Gang, and the Sony-produced historical epic Heroes of Heaven and Earth. Most ambitious of all is the $30m Hero, made with money from Hong Kong, China and the US. This epic combines the formidable talents of Jet Li, Zhang Ziyi and Hong Kong superstars Maggie Cheung and Tony Leung Chiu Wai. Ironically, it is based on the same story as Chen's flop The Emperor and the Assassin. Even more ironically, its director is Zhang Yimou.

It would be easy to describe this as selling out, but from Zhang's perspective it is more a case of making the type of film he has always wanted to. And why shouldn't he? If anyone deserves to benefit from the rise of Chinese cinema, it is Zhang. The Fifth Generation was criticised for directing its early films at international audiences; but considering conditions at home back then, there was really no one else to target.

Now there is. For the first time in living memory, Chinese directors have options beyond the festival/ arthouse route. They can make modern films for their own citizens and they can make mass entertainment for global audiences. Ideally, once commercial cinema is running smoothly in China, the state-run studios will again have room to accommodate new arthouse directors. Perhaps then the international connoisseurs who lament the good old days of Raise the Red Lantern will get what they want. In the meantime, at least everybody else - Chinese audiences, global action fans and the directors - is relatively happy.